Spreading risk only works if you don't spread too far

Marcus Padley -Mar 31, 2012

THERE has long been an argument about diversification. It starts with the rather astounding mathematical revelation and the basis of portfolio optimisation, that two risky stocks together are less risky than one risky stock, an insight that is contested by the rather indisputable wisdom that "If you know what you're doing, why would you diversify?"

But the main issue for the private investor considering whether to trade individual stocks or buy a diversified portfolio is not about avoiding responsibility, it is about avoiding effort. Diversification is about laziness being endorsed by financial theory. It is about buying enough stocks to dilute the impact of your mistakes. It's about not having to do anything after buying.

And on a commercial level it is used as a core sales proposition by the managed funds industry. For a small sum of money you can buy exposure to a lot of stocks. And if you go to a financial planner, by the time you leave their office you will have bought 3000 stocks in three different countries and 10 different asset classes.

But amid all this risk minimisation no one bothers to explain that at best your end return is going to be an average of all the averages less fees iced by the inner glow that comes from having kept a lot of BMW dealers in business. There's no transformation in diversification, just a lot of marketing promises and the market return less costs.

Now let's go to the other end of the spectrum. Imagine you had all your money in one stock. Would you be focused? Would you be finding out everything you possibly could about that company? Would you know more about that company than 99.99999 per cent of investors? Would you know what it did? Would you attend its meetings? Would you know the history and background of the CEO and the board?

And if you only had one huge position in one stock would you bounce out of bed to find out what the overnight markets did? Would you watch the market on open? Would you be micromanaging the trade? Would you be reading books about trading techniques and technical analysis? Would you be developing a pyramiding (buying more when it goes up) strategy and a stop-loss strategy? Would you be obsessed? Of course you would, if all your money was in it.

The more risk you take, the more you want to understand, minimise and control that risk and the more engaged you will be with your investments. Compare that to putting all your money in a portfolio of 10 to 20 stocks that were picked out because they were big and well known, that you don't really know, don't really pay attention to but are comfortable with because it is a diversified portfolio. What sort of risk management is that?

A one-stock portfolio forces you do everything right, whereas the 10-20-stock portfolio of blue chips (the ''Moron Portfolio'') breeds complacency, inaction and ignorance. Which approach would you rather stake your future on? Which one do you think is more risky?

The one-stock portfolio is an extreme example, but because it substitutes commitment for apathy it is arguably less risky, although ultimately it doesn't matter how many stocks you have as long as you are engaged and the engaged investor sees every stock as a separate battle, every trade an isolated experience and because of that most successful (and unsuccessful) traders will be able to tell you the exact stock they made or lost their money in.

But one stock is too few and 20 too many, so a lot of traders will tell you to target about five. You'll make more money trading five stocks you know extremely well than you ever will investing in 20 stocks you ignore.

I used to trade Webjet a lot. Wish I still did. It had/has a strong underlying driver, the growth in online bookings of flights and accommodation. Knowing that was all the risk management you needed. Your job in a market going nowhere in a hurry is to find your own stocks that have a strong underlying driver and get to know them better than anyone else. When everyone else is diversifying, finding an edge is just a few hours away.

Marcus Padley is a stockbroker with Patersons Securities and the author of stockmarket newsletter Marcus Today.

For a free trial go to marcustoday.com.au. His views do not necessarily reflect the views of Patersons.